"Bad" debts are the phenomenon that is hardly new to the Russian banking sector. During the periods of economic growth banks undersell solution of this problem, but during a recession it escalates to the maximum and becomes a constant headache for many financial institutions. The Man­aging Partner of Holdsway LLC, Konstantin SEMENKO explained in NBJ interview the difficulties that the banks with a significant share of dis­tressed portfolio assets may face.

NBJ: Konstantin Nikolaevich, what is the relevance and importance of the "bad" debt for banks?

K. SEMENKO: I think that among the prob­lems that credit and financial institutions face in their daily activities, the issues related to existing distressed assets are the most relevant and important. To confirm this thesis, let's look at banking statistics for the last few years.

According to data released by the Central Bank for the period since the 1st of January 2012 to the 1st of February 2014 the volume of crediting increased by a third. The financial institutions invest­ments in debts increased by 50% and the bank participation portfolio in subsidiar­ies and associated joint stock companies increased twice. During the same period the arrears on loans increased by about a third, and were slightly less than 4% or 1.5 trillion rubles in volume terms.

With sufficiently high probability we can assume that the same dynamics is recognized in relation to debt security, equity security and subsidiary joint stock company (affiliate) investments. Taking into account the absolute values of the respective investments and the fact that, as a rule, all the investments in some way are provided by some assets, the following picture beginning to emerge: the volume of bad assets as of February 2014 may be about 1.8 trillion rubles in volume terms, which corresponds approximately to the volume of industrial production in the country in 2012. Here is another indica­tor. Since the beginning of 2012 the num­ber of unprofitable credit institutions qua­drupled with an overall reduction of credit institutions by 10% over the same period.

Of course, the relationship between the growth of bank bad assets volume and the profitability reduction is not obvious, but you must admit, it requires under­standing and careful consideration. It is good that the banking community pays attention to this issue though perhaps this attention is not enough.

NBJ: In your opinion, what is the current structure of bank distressed assets and will this structure change in a short and a long term?

K. SEMENKO: The structure of problem assets is approximately constant over the last few years. The assessment of the situ­ation, which is performed today, allows suggest that the bulk of bad assets is con­centrated in real estate and in the stocks (shares) of subsidiaries or affiliated com­panies. It is difficult to determine more precisely because often enough the tenure is presented by credit institutions as the ownership of shares in share investment funds or subsidiary stocks (shares).

However, in recent times, this struc­ture of assets begins to change. Previ­ously, for example, a bank could afford not to lend under assets security that were uncomfortable in terms of assets possible control in the future. Now it seems that the financial and credit institutions will be forced to change and start to accept other assets besides real estate.

It's a kind of competitive advantage for a bank. If it has the opportunity on acceptable risk conditions to accept some property as a credit security which cannot be accepted at any reason by other mem­bers of the lending market, it is definitely a positive trend for it. An interest income is added by the revenue from account trans­actions in a crediting bank - a decent port­folio results.

NBJ: What are the costs and risks for credit institutions because of distressed assets?

K. SEMENKO: It's a complex and multi-aspect question. In short, there is a pool of costs and risks associated with capital buffers.

The reserve requirements established by a regulator are not always understood by tax authorities as the reserves are bank's expenses during the correspond­ing period and reduce the taxable base in respect of an income tax.

There are cases when an organization performed CB regulations on the estab­lishment of additional reserves, but the tax authorities considered such additional reserves as economically unjustified costs and made a bank pay additional taxes.

It is clear that in such a situation, credit market participants sometimes try to ta­ke problem assets from the need of addi­tional reserves creation. Distancing mech­anisms of a bank from "bad" debts and non-core assets are more or less known, but there are always new ways, often not always thoughtful and legitimate.

A bank distancing from"bad" debts and non-core assets reduces the risks of additional capital buffers, but there are other risks: loss of corresponding assets management. We had to deal repeatedly with a legitimate assets return to credit institutions that were so remote so that the banks could not properly monitor com­pany management which formally owned these assets. As a result, the assets were alienated or lost.

Another, probably the most common pool of costs and risks is associated with insufficient quality of asset management and as a result the obtaining of losses that become evident in the bank sector.

In our opinion, the factor that con­tributes to substantial risk reduction is the involving to the management or sell-off of assets third-party independent profes­sional managers. Moreover, I believe that such experts may be engaged to assist the bank employees as well as for indepen­dent professional evaluation of the bank employees' performance. In world prac­tice, it is called a second opinion.

NBJ: In your experience, is the presence of the abovementioned risks and problems natural only for small and medium banks, or do the major players in the Russian bank sector also experience such risks and problems?

K. SEMENKO: One of the problems for small and medium banks is that they do not have sufficient resources or do not wish to spend a lot on skilled management of distressed assets. But this does not mean that the market leaders are completely spared from the headaches caused by the presence of "bad" debts in their portfolios. I know the largest Russian banks, which through a complex internal structure of communication have the same amount of problems with such assets and maybe even more than the small and medium players.

NBJ: What is the relation of distressed assets risk minimization with the problem solution concerning the determination of a fair value for such assets?

K. SEMENKO: This is one of the global issues in Russian law enforcement. I already men­tioned a bank dispute with a tax authority concerning the validity of reserve volume estimate. Such conflicts could be avoided if there were common approaches agreed with all stakeholders concerning the essential facts evaluation related to distressed assets.

NBJ: You mentioned the tax risks associ­ated with distressed assets. Could you tell us more about the essential and typical tax risks arising from banks in this area? What are other pitfalls and conflicts for the banks - the owners of distressed assets?

K. SEMENKO: This is a very complex and important question. To illustrate this, I'll mention one example. Several interrelated credit agreements, real estate sale contracts and shares, as well as the assignment agree­ment were signed with a very reputable bank and its affiliates. During a tax audit a num­ber of circumstances concerning transac­tions (e.g., company transaction contractors and the assets which are the subject of these transactions), as well as some indirect cir­ cumstances allowed the tax authority come to the following conclusion: the transac­tions have no other economic purpose other than technical restructuring of the bank bad debt. That is, the thing is actually about bad loan debt restructuring for the financial and credit institution.

Bad debts on loans, credit and simi­lar debts must be repaid from the amounts generated by bank reserves and accord­ing to article 292 of the RF Tax Code, the Letter from the Ministry of Finance № 03-03-06/2/6 issued on 21.01.2010 and the letters from the Ministry of Finance № 03-03-06/2/128 issued on 02.07.2009 the amount of reserves for possible losses on loans previously classified as non-oper­ating expenses shall be restored in account­ing and are recognized as the bank revenues.

Without going into details of the case, I can say that we managed to convince the tax authorities in their unfounded assump­tions. We provided for inspection authorities the documents confirming the implementa­tion of all the treaties by all the parties on the actual legal actions obviously necessary for the implementation of corresponding con­tracts under normal economic circulation.

In other situation I do not rule out that the abovementioned transactions can be deemed as the transactions aimed at obtain­ing of an unjustified tax benefit in terms of value added tax and income tax, which could lead to additional charge of appro­priate taxes. Although such claims of tax authorities are currently not common, we do not exclude a significant increase of the state interest in these issues.

NBJ: It's no secret that banks seeking to disguise the presence of distressed assets in their portfolios establish closed mutual funds. What are the tax collisions in such a situation?

K. SEMENKO: This question cannot be ans­wered in general without taking into account a particular transaction. There are too many options of bank assets trans­fer under CEF management. There is one more general rule.

In the early 2000s, no tax lawyer would believe you if you told him that a taxpayer may be liable for taxes that were not paid by the taxpayer counterparty. Despite this, for more than ten years the tax authority has been replenishing the budget with the funds collected from taxpayers who did not take sufficient measures from the point of view of tax authority to check whether their coun­terparty is a fly-by-night company. There­fore, I was always very cautious about the claims of credit institution representatives on the absolute legality of CEF formation by distressed bank assets.

The modern law enforcement practice is on the way to determine the real purpose of an action in economic circulation. And if it is obvious that the purpose of the busi­ness transaction was not the same as it was declared the rules for this transaction may be applied pertaining to the operation that the parties really meant. Therefore it is nec­essary to analyze specific transactions and assess them including the evidence for the presence of other economic purposes other than the restructuring of bad debt or the desire not to apply the reserve requirements established for non-core bank assets.

NBJ: In your opinion what changes in the legal regulation of financial institutions associated with distressed assets would be useful for the banking community?

K. SEMENKO: Responding to a question, I would like to draw the attention of the banking community on the usefulness of developing an operational standard for distressed assets once again. The pres­ence of such a standard will contribute to the harmonization of banks and regula­tor approaches concerning controver­sial issues of credit institutions with dis­tressed assets. It will provide additional mechanisms of a risk based assessment at the determination of developed reserves amount for problem assets and the prov­en best practices of dealing with problem assets and the forms of documents for such work. Besides, such a standard will reduce the cost of financial institution audit, the cost of legal and consulting services for distressed assets support and certainly will increase the confidence of business com­munity and counterparties for banks.